Over-the-counter market makers are girding for another fight over ECN access fees.
The Financial Industry Regulatory Authority has reintroduced a proposal to allow alternative trading systems and ECNs to charge access fees without incorporating them in their quotes. And this has OTC dealers hopping mad because they believe it puts them at a competitive disadvantage with ECNs.
Under the proposed changes, FINRA would eliminate the requirement that ECNs and ATSs display their fees in their quotes, but such a rule would place limits on the size of those fees. The change to FINRA Rule 6540, if approved by the Securities and Exchange Commission, would benefit ArcaEdge, operated by a unit of NYSE Euronext, and the only ECN-like facility in the OTC market. The rule change is specifically aimed at the OTC Bulletin Board marketplace and not the Pink Sheets. Both make up what is known as the OTC market.
"We are in favor of anything that improves market transparency; however, removing access fees from displayed ECN quotes is a step backwards," Knight Capital Group chief compliance officer Mike Corrao told Traders Magazine. Knight is the largest market maker of OTC securities.
Dealers are opposed to allowing ECNs to forgo access fees in their quotes for a variety of reasons. First, they contend the move would put them at a competitive disadvantage vis-à-vis ECNs because the full price of a given security would not be reflected in the ECN’s quote.
Under the proposal, the ECN could quote at the same price as the market maker, even though the final price would be inferior by the amount of the access fee. Today, by contrast, traders quoting on ArcaEdge must take into account the ECN’s fee when pricing their orders in competition with dealer quotes.
"You shouldn’t discover a hidden fee after you take or hit a market," Corrao said. "People should see the true cost of the shares in the public quotation."
Dealers also oppose the change to Rule 6540 because it would mean dealers, as the primary takers of liquidity from ArcaEdge, would receive a bill every month. They would have to pay that bill; whether they would seek reimbursement from their customers is an open question. Today, they simply pass the ECN fee on to their customers as part of the net cost of the security.
If market makers did pass the fees on to their customers, those customers would never again be sure of the price they were likely to get when placing an order, said Nick DeMaria, managing director of equities trading at discount brokerage StockCross Financial Services. "How will they be able to differentiate? The inside market is not necessarily going to tell them."
Another possible outcome, market makers say, is that if dealers start getting billed for their ECN trades, they might start billing others for trades done against their quotes. "If Arca can quote a stock and then bill, then every dealer is going to do the same thing," DeMaria said. "In the dealer community, it will be a zero-sum game."
FINRA first proposed removing the access fee display requirement in the OTCBB market in 2005 in conjunction with a proposal to restrict sub-penny quoting in OTC securities. Because ECN access fees are typically priced in fractions of a cent, ECNs would be unable to comply with any bans on sub-penny quoting if they had to incorporate their fees into their quotes. That’s why FINRA proposed alleviating them of their obligations under Rule 6540.
The two proposals went nowhere, however, after dealers protested the removal of access fees from ECN quotes.
Then, in 2007, FINRA tried again to rescind the access fee display requirement. This time it argued its rescission was necessary so that ECNs did not publish two different quotes from the same supplier: one without a fee to its members and another with a fee to non-members. The regulator also argued the two different quotes unnecessarily resulted in two trade reports instead of one.
To sweeten the deal for market makers, FINRA required ECNs to incorporate access fees into their quotes if the fee exceeded a certain amount. If the stock was trading at $1 or more, then all fees greater than $0.003 had to be included in the quote. For stocks trading at less than $1, all fees equal to 0.3 percent of the stock’s price had to be incorporated into the quote. These requirements effectively capped the amount ECNs could charge for access.
Still, market makers weren’t having any. And once again FINRA pulled the proposal.
FINRA’s current proposal to restrict sub-penny quoting is little changed from its 2005 version. This time, however, for purposes of the new Rule 6434, FINRA has divided the OTC world into three price tiers instead of two.
FINRA’s current proposal to the change access fee rules is little changed from its 2007 version. Once again, FINRA has proposed eliminating the access fee display requirement. In its place, the regulator has proposed access fee caps. Per Rule 6450, if the quote is $1 or more, then the fee is limited to $0.003 per share. If the quote is less than $1, then the fee is limited to 0.3 percent of the quote.
Those cap levels might be on the high side, some contend. Cromwell Coulson, chief executive of Pink OTC Markets, the operator of an OTC trading service, believes that any fee has to be considered in relation to the minimum trading increment. "When access fees are larger than the quote increment, they are not de minimis," Coulson said.
Under FINRA’s sub-penny quoting proposal, a stock trading for between 1 and 99 cents, for example, must trade in increments of $0.0001 (one-100th of a cent). Fee caps under FINRA’s fee cap proposal would almost always exceed the minimum tick in that bracket.
Referring to the proposal, Coulson said: "Either quote increments need to go up or access fees need to be limited to 30 percent of the quote increment."
Both rules are modeled after similar rules found in the SEC’s Regulation NMS, which applies to trading in National Market System stocks. The two rules are part of a package of four rules being proposed by FINRA that also include one that addresses limit orders and one that deals with locked and crossed markets. All four rules are similar to those found in Regulation NMS. FINRA maintains they should be applied to trading in OTC securities, as well.
ArcaEdge launched in 2003. It has gradually built up its market share but still accounts for less than 5 percent of total OTCBB volume. The ECN would not comment for this article but has been supportive of FINRA’s previous efforts to change the access fee rules.
In a comment letter to the SEC in 2007, the ECN voiced its support for all four of the rules currently under proposal as necessary steps in the "modernization of the OTCBB marketplace." The ECN told the SEC it would like to see the OTCBB transformed "from a dealer-driven market to an order-driven market." It expects the removal of the access fee display requirement will encourage more ECNs or ATSs to enter the OTCBB marketplace, furthering that goal.
ArcaEdge contends market makers hold an unfair advantage over ECNs because of their ability to "mark up shares from their inventory prior to effecting a transaction with a customer." The ECN also does not believe the absence of fees in quotes would be misleading because any rule would assure "order routers that displayed prices are, within a limited range, true prices."
The SEC put FINRA’s proposal out for public comment last week. In 2005 and 2007, the issue drew a large number of negative comments from market-making firms and their representatives. Dealers expect a similar onslaught this time, as well.
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